Why did lenders modify so many loans during the housing bust?

Unilaterally modifying home mortgages was a necessary step to ensure banks survived the housing bust.

Ostensibly, homeowners and lenders agreed to the price of money (interest rate and payment) when the promissory note was signed. Unfortunately, during the housing bubble, the terms of these notes were onerous, and many borrowers faced excessive monthly housing costs while simultaneously facing declining house prices and the elimination of their equity.

With no equity, little hope of future equity, and rising payments, many borrowers opted to strategically default — and lenders worried that more would follow. Banks were still exposed to $1 trillion in unsecured mortgage debt when housing collapsed. The threat of strategic default and the reality of a trillion dollars in unsecured debt forced the banks to renegotiate the terms of the original promissory note, and loan modifications became a feature on the real estate landscape.

Lenders don’t want to make loan modifications. If the borrowers had equity, they would simply foreclose on them and get their money back. Since so many were so far underwater, the banks couldn’t foreclose on them and get all of their money back, so it was in their best interest to cut deals, amend loan terms, kick the can, and pray their borrowers made payments until prices came back.

Once prices reached the peak, things changed back in favor of the banks, and their motivation to make loan modifications vanished. Many people view loan modifications as a new housing entitlement. Beyond the new statutory requirements, it won’t be.

The moment borrowers are no longer underwater, the entitlement is rescinded by the banks. Remember, they would rather foreclose and get their money back so they can loan it to someone who will make payments based on the original contract terms.

The money rentership negotiation

The negotiation of terms for loan modifications is unique. Never before were so many been in such circumstances, so there was no precedent for this activity. Ordinarily, the lender wields far more power than a landlord because the eviction of a homeowner (also known as a foreclosure) trashes the credit score of the borrower.

Lenders demand payments for renting money that exceeded the fair market rent on the property — and homeowners willingly paid it, partly out of fear, and partly out of greed. Borrowers feared the ramifications of the foreclosure, but they also believed prices would come back, and they would still make a fortune on home price appreciation — albeit delayed by a decade.

For example, let’s say a loanowner was facing a $3,500 payment on a property that rented for $2,000 — a common occurrence in the aftermath of the housing bubble in California. The borrower could have simply strategically defaulted and squatted until the lender foreclosed. They could then rent a similar property for $2,000 per month. Many followed this path.

However, after examining the borrower’s finances, many banks offered a loan modification that reduced the payment to $2,500 interest-only on a temporary basis if the borrower started paying again. Since the bank made up the formula anyway, they spit out whatever number they believed they could get the borrower to pay. Since the borrower had credit consequences to walking away in favor of rental, and since the borrower maintained hope of future equity, many borrowers paid the extra money to stay in the house.

The win-win of rising prices

Every underwater homeowner was a potential loss for the lender. If that borrower stopped paying or asked for a short sale before prices reach peak valuations, the bank absorbed a loss.

Banks don’t want to recognize losses either by foreclosure or short sale. They would far prefer to borrowers to stay in their homes, pay something, and wait for house prices to reach the peak where lenders had no exposure. Most homeowners were happy to play along. The only thing lacking up through early 2012 was rising prices to give both lenders and homeowners hope.

To get prices to go back up, lenders needed to drastically reduce the MLS supply to create a false shortage the forces buyers to compete and bid prices up. Once prices started to rise, and once homeowners believed the rise was sustainable, many of them signed up for loan modifications. As far as lender and homeowners are concerned, this was a win-win. The only losers in this scenario are future homebuyers, and as I’ve pointed out before, nobody cares about them.

13 responses to “Why did lenders modify so many loans during the housing bust?”

Fannie Mae held its economic growth forecast steady in April at 2% for the year, saying policy changes that could result in meaningful economic growth seem unlikely for this year, according to the company’s economic and strategic research group’s April 2017 Economic and Housing Outlook.

The outlook explains that while confidence among consumers and in the industry is currently high, near-term risk of a potential government shutdown could bring confidence levels down.

Last month, Fannie Mae announced it would be taking a “wait and see” approach to some of President Donald Trump’s policies.

“Our economic forecast remains unchanged in April as we continue to await details on the new Administration’s plans,” Fannie Mae Chief Economist Doug Duncan said. “We’re intrigued by the disparity between elevated consumer and business optimism and signs of decelerating first-quarter economic growth.”

“However, we expect growth to rebound this quarter as special factors that weighed on growth partially unwind,” Duncan said.

The U.S. economy could grow sluggish as President Donald Trump moves forward with his pro-business policies, billionaire real estate investor Jeff Greene told CNBC on Monday.

“I think we have been in a period of insane ‘animals spirits,'” Greene said on “Squawk on the Street,” citing previous inaction in Washington.

The founder of the Greene Institute said that the assurances from the Trump administration that they will get things done may slow the economy, perhaps leading to a rise in interest rates.

“I think the economy is mature. … I think we’re more likely to have a slowdown to 0 percent growth than an increase to 4 percent growth, so I’m very cautious. I still maintain a lot of my core positions. But you know I have definitely cut back on my equities, by I’d say, 50 percent over the last year,” he added.

“I think there’s more room below us,” Greene said, noting that many areas of the stock market seem to be peaking.

While low housing inventory and slow wage growth are par for the course in California, the state pushed past those roadblocks to record a strong start to the year, according to the California Association of Realtors’ latest report, which collects data from more than 90 local Realtor associations and MLSs statewide.

Closed escrow sales of existing, single-family detached homes in California totaled a seasonally adjusted annualized rate of 416,580 units in March, staying above the 400,000 benchmark for a full year. This is up 4% from the 400,720 level in February and up 6.9% from the revised March 2016 level of 389,770.

CAR noted that the statewide sales figure represents what would be the total number of homes sold during 2017 if sales maintained the March pace throughout the year. It is adjusted to account for seasonal factors that typically influence home sales.

The chart below shows the total sales of existing, single-family detached homes in California, dating back to January 2005.

“March’s solid sales performance was likely influenced by the specter of higher interest rates, which may have pushed buyers off the sidelines and close escrow before rates moved higher,” said CAR President Geoff McIntosh. “The strong housing demand, coupled with a shortage of available homes for sale, is pushing prices higher as would-be buyers try to purchase before affordability gets worse.”

Last week Angelenos voted against a proposed measure that would have curtailed new development for two years as the city prepared to overhaul and repair its zoning codes.

The measure was backed by the president of the AIDS Health Foundation, whose office on the 21st floor of a skyscraper overlooks the hills – a view that is set to be interrupted by two new 28-story mixed-use properties. Angelenos voted against the measure, effectively paving the way for higher density projects to help housing issues.

“I see a series of many urban centers along the transportation corridors,” said Nelson Rising, chief executive of Rising Realty Partners, which has worked extensively in downtown Los Angeles.

“Anything near a transit stop will become viable and attractive,” Mr. Rising said. He pointed to specific hubs of density along the purple line, which currently links downtown to Koreatown and is set to extend all the way to Santa Monica with the passage of the transit measure. He also pointed to the Expo Line, which runs parallel to Interstate 10 and connected downtown to Santa Monica in May 2016.

The city planning department has laid the groundwork for these changes. Last year it enacted a mobility plan to diversify transportation modes by 2035, and created a new industrial live-work zone in response to demand from commercial and residential sectors for that kind of multiuse development.

Employers in Southern California are struggling with luring the best and brightest workers to the area in part because of high housing costs.

According to Business Insider, a new report from the University of Southern California and the Los Angeles Business Council found that majority of the employers said that the high cost of living in L.A. negatively affects employee retention, and three-quarters of respondents said that housing costs were a specific concern. Ten of the 14 employers surveyed said that expensive housing is a “barrier” to hiring new mid- and upper-level employees.

In Los Angeles, the median home value is $616,900 and the median rent is about $2,860, which are considerably higher than the national median home value ($195,700) and rent ($1,500).

Companies such as Boeing and SpaceX have either moved or opened new facilities out of state in an effort to attract talent.

“It’s concerning that high housing costs could lead to Los Angeles losing its competitive edge in recruiting top talent. That would be devastating to our economy,” Mary Leslie, president of the Los Angeles Business Council, said.

Ultimately, it’s not. That’s why California will no longer have a permanent working class. Only the most highly paid professionals will own houses. The rest will endure high rents until they give up and leave the state. The high wages will continually draw new people in to replace those who get frustrated and leave. It’s a terrible system, but that’s what we have now in California.

Also, future homebuyers are not the only losers. Nope! The populous are losers simply because the purchasing power of their labor continues to be stolen via a ‘sleight of hand’ type trick called Inflation.